Trade Policy in the Shadow of Conflict: The Case of Dual-use Goods

Policymakers increasingly use trade instruments to address national security concerns. This paper studies optimal policy for dual-use goods, items with both military and civilian applications. We begin by documenting that regulation and trade flows of dual-use goods respond to changes in security environment over time. To put structure on our problem, we introduce defense procurement into a trade network model and add a military contest externality to the national welfare function. In a simple two-country case, optimal export taxes depend on the trade-off between the good's military centrality and its distortion centrality. Military centrality is a network-adjusted sales share to the foreign military; distortion centrality reflects taxation misallocation in the domestic economy from roundabout imports. Using U.S. defense procurement data, we construct empirical counterparts to our optimal tax formulas and show that those are associated with policy targeting and trade responses around conflicts. The resulting pecking order of dual-use goods allows us to evaluate the U.S. security restrictions and sanctions against Russia. To quantify the macroeconomic magnitude of the consumption-security trade-off, we calibrate our model to a potential U.S.-China conflict. Our revealed preference estimate of the conflict prize amounts to 250% U.S. GDP.